I am self-employed. I used to put money in Roth IRA but then I started to make more than the limit so I stopped. I now read your article about the backdoor Roth. I put the max for self-employed in an SEP IRA: 50k. So now (since 2010 per your article) I can put $5000-5500 (2012,13) into this backdoor Roth. Do I need to reduce my SEP contribution to 45k to set this up or are they separate IRAs? I have 20+ yrs til retirement. Thx for any advice in advance.
The government places no restrictions on contributing to both a SEP IRA and a Traditional IRA in the same year so you do not need to reduce your SEP IRA contribution to also contribute to a Traditional IRA. As you note, however, there are income limits to deducting contributions to a Traditional IRA. As this IRA contribution limit table shows, those with workplace retirement plans can only take the full deduction on a Traditional IRA if their income is less than $59k ($95k if married). So for high earners like you, the $50k you contribute to the SEP IRA (see IRS limits) would be tax deductible while the $5,500 contributed to the Traditional IRA would not be.
So can you get that non-deductible money into a “backdoor” Roth IRA? Yes, but be careful. There are no income limits on rolling over a Traditional IRA to Roth IRA so you are certainly welcome to do so. The catch is that the government requires all rollovers from Traditional to Roth IRAs be done on a pro-rata basis. This means that if you have an account with a $50k SEP IRA contribution and a $5,500 Traditional IRA contribution, you cannot choose to just rollover the $5,500. If you rolled over $5,500 (10% of your account total), the government would treat that like you were rolling over $5,000 of the SEP and $500 of the non-deductible Traditional IRA, which is not what you intended at all. Unfortunately, you don’t have the option of designating which dollars are getting rolled over.
The only way to rollover the full non-deductible amount into a Roth IRA would be to rollover all of your traditional assets (this includes the full value of your SEP IRA and other Traditional IRA accounts). If you think taxes will go up in the future, this might not be a bad idea, but you will owe the taxes immediately. If you have been contributing to the SEP IRA for some time, your tax bill could be substantial.
If you’re not ready to convert it all to Roth, you still have the option of making the non-deductible IRA contribution and just leaving it non-deductible. The tax advantages are not as great as with a deductible Traditional IRA or a Roth IRA, but this structure is still superior to a fully taxable account due to the deferment of dividend and capital gains taxes for your 20+ years until retirement.
About the Author
Joanna D. Pratt, CFA is an experienced institutional investor. She holds a bachelor’s degree in economics and certificate in finance from Princeton and an MBA from Stanford.
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